Kiss the Global Financial System Goodbye?

The Chinese fret over Fannie and Freddie.

"The end of the current international financial system." That's how Yu Yongding described the result if government-sponsored mortgage giants Fannie Mae(NYSE:FNM) and Freddie Mac(NYSE:FRE) were to fail.

Why should we care what one man in China thinks about our domestic financial institutions? Well, Yu happens to be a former advisor to the Chinese central bank, and he remains influential in government and financial circles.

Guess who owns much of Fannie and Freddie's debt?Oh, by the way, China is by far the largest foreign investor in U.S. long-term agency debt. The $376 billion of those assets China holds represents more than one-fourth of all foreign holdings. Most of these assets are in Fannie and Freddie debt, and most them are thought to be controlled by China's central bank.

Just today, The Wall Street Journal reported that the China's four largest listed banks have reduced their exposure to Fannie and Freddie obligations by almost half since the end of 2007.

In a way, that behavior doesn't make sense, since the U.S. government's backing of these obligations has arguably never been more explicit than it is today. Still, the U.S. Treasury must deal with the reality that investors believe these assets' riskiness has increased.

Fannie and Freddie aren't just a domestic issueCountries have never been more interconnected than they are today. Just look at the direct investments made by foreign countries in a who's who of the U.S. financial system: Citigroup(NYSE:C), Merrill Lynch(NYSE:MER), Morgan Stanley(NYSE:MS), Blackstone(NYSE:BX) and Nasdaq OMX(NASDAQ:NDAQ).

Treasury Secretary Hank Paulson thought his "bazooka" might be enough to reassure investors about Fannie and Freddie's stability. The news from China adds pressure on Paulson to map out a detailed solution to the plight of these two institutions. Failing that, the debt markets could witness more Chinese fireworks.